Monday, September 28, 2009

Starting Findory: Acqusition talks

[I wrote a draft of this post nearly two years ago as part of my Starting Findory series, but did not publish it at the time; it seemed inappropriate given my position at Microsoft and the economic downturn. Recently, Google and Microsoft both announced ([1][2]) that they intend to make 12-15 acquisitions a year, which makes this much more timely.]

At various points when I was running Findory, I approached or was approached by other firms about acquisition. For the most part, these talks went well, but, as with many experiences at Findory, my initial expectations proved naive. It gave me much to contemplate, both for what startups should think about when entering these talks and changes bigger companies might consider in how they do acquisitions.

For a startup, acquisition talks can be a major distraction. It is time away from building features for customers. It creates legal bills that increase burn rate. It distracts the startup with nervous flutters over uncertainty over the future, potential distant payouts, and the complexity of a move.

Acquisition talks also can be dangerous for a startup. Some companies might start due diligence, extract all the information they can, then decided to try to build themselves.

There is some disagreement on this last point. For example, Y-Combinator's Paul Graham wrote, "What protects little companies from being copied by bigger competitors is ... the thousand little things the big company will get wrong if they try." Paul is claiming that big companies have such poor ability to execute that the danger of telling them everything is low.

However, big companies systematically underestimate the risk of failure and cost of increased time to market. For internal teams, which often already are jealous of the supposedly greener grass of the startup life, the perceived fun of trying to build it themselves means they are unreasonably likely to try to do so. Paul is right that a big company likely will get it wrong when they try, but they also are likely to try, which means the startup got nothing from their talks but a distraction.

There are other things to watch out for in acquisition talks. At big companies, acquisitions of small startups often are channeled into the same slow, bureaucratic process as an acquisition of a 300-person company. Individual incentives at large firms often reward lack of failure more than success, creating a bias toward doing nothing over doing something. In fact, acquiring companies usually feel little sense of urgency until an executive is spooked by an immediate competitive threat, at which point they panic like a wounded beast, suddenly motivated by fear.

Looking back, my biggest surprise was that companies show much less interest than I expected in seeking out very small, early-stage companies to acquire.

As Paul Graham argued in his essay, "Hiring is obsolete", for the cost of what looks like a large starting bonus, the companies get experience, passion, and proven ability to deliver. By acquiring early, there is only talent and technology. There is no overhead, no markups for financiers, and no investment in building a brand.

Moreover, as the business literature shows, it is the small acquisitions that usually bring value to a company and the large acquisitions that destroy value. On average, companies should prefer doing 100 $2-5M acquisitions over one large $200-500M one, but business development groups at large companies are not set up that way.

There is a missed opportunity here. Bigger companies could treat startups like external R&D, letting those that fail fail at no cost, scooping up the talent that demonstrates ingenuity, passion, and ability to execute. It would be a different way of doing acquisitions, one that looks more like hiring than a merging of equals, but also one that is likely to yield much better results.

For more on that, see also Paul Graham's essay, "The Future of Web Startups", especially his third point under the header "New Attitudes to Acquisition".

6 comments:

Hi, David. I think it is more a matter of prioritization than filtering. Focus on product and try to minimize the time spent on competition. I think the best way to build value is to build something customers clearly want.

To take a specific example, at Findory, I might have succumbed to the temptation to talk to companies I might not want to be acquired by -- perhaps hoping they would make an offer too good to refuse or that it would strengthen my position with others -- but I think that time would have been better spent on customers and product.

Very interesting post, Greg. Having been on both sides of what you are talking about, I can very much relate with what you say and agree with the fact that there is a missed opportunity. Though as you say, big companies (minus a few, Google I think being one) don't know how to deal with startup structures, as they will impose their well oiled processes and extinguish the entrepreneur creative minds like monsoon rain on a fire.

Good arguments. On balance most of the few current acquisitions are about growing revenue (>$10m turnover required) or users (>1m users required) rather than acquiring technology or taking a strategic position.

Most company R&D teams are of the opinion they can do better than ANY start up company in any field, but they are smart enough to know that they cannot do better than EVERY start up. In other words, there will always be new things that come out of the left field that the big company R&D team did not see or did not have time to deliver on.

Just sometimes, this new thing from a start up is interesting enough to be acquired, but usually only if there is a bidding war and a massive "burning platform" that the acquirer is aware of.

This should suggest to all start ups that, rather than wait to be found, they should be planning strategically to find the company that *needs* to buy them, and courting them assiduously for a couple of years as the company grows. This will take about 90% of a senior execs time, which is why having a savvy Non-Exec (Chairman, President) do it for the team is a smart idea.

Two other little things popped up when I was running start ups:

1 - the "Microsoft Formula" was widely held to be "it will cost MS about 10x what it cost you to develop, because of their massive corporate overheads, legals, compliance rules, and so on. So if they can buy you for <10x your costs to date, then a deal is possible"

2 - both MS and Google both employ(ed) quite a few ex-CIA corporate analysts in their acquisition teams. Those guys know/knew a thing or two about strategic acquisition of information. Getting on their radar was not too hard if you were in the right space. :-)

Greg - great observation about this opportunity (mostly missed by big tech companies). Though you rightly point out the challenges large companies have in acquiring small start-ups (I worked in both big companies includind Amazon, and several start-ups).1. BD/Corp Dev doesn't think about it as R&D and even if they do - the people required to do due diligence tend to be the same technical folks who were tasked with doing what the start-up just did but failed (either failed to see it, or failed to execute - either way, they're not exactly open minded).2. On the business side, there are other issues - small deals don't move the needle for a business leader, so it usaully isn't a priority until it's too late and if it's big - missing the opportunity. 3. Finally, the corp dev guys come from finance, typically - where size matters... (and considering there's roughly the same amount of work in doing a smaller deal versus a medium sized deal - they'd just rather do bigger deals)

Advice to start-ups (and why some of the deals get done right): the few exceptions, are typically CEO-driven (or at least exec team led), strategic acquisitions in early stage companies such as you describe. So for start-ups... one key criteria in deciding to take or push off the acquisition discussion is WHO at the company is driving the meeting (not who is in the meeting, but who seems to be pushing for it to happen) - if it feels like it's driven by biz dev, by a junior biz owner or an engineer, share enough info to get them exciting but don't dive deep or spin too many cycles until you have someone who's job it is to think about how/why this helps their business - in a strategic way - because honestly, if they're paying <$10M, you're not going to be adding revenue that matters to their P+L for some time. If you can figure out WHO in the org is excited about buying you and WHY = this can be invaluable in deciding how, and how openly/aggressively to proceed.